Shares in Rolls-Royce have become one of the most high profile underperformers of recent years. However, despite the share price now sitting some 50% below its all-time high I’m still not tempted to buy.
There are two main reasons:
- The company has a pension scheme which I think is dangerously large
- The share price just isn’t low enough
If those two issues were somehow fixed I would be more than happy to invest because, by most other measures, Rolls-Royce appears to be a solid (but not infallible) company.
A successful company but not quite as defensive as investors thought
There are a few important features that I want any potential investment to have, such as a long history of dividend payments, consistent profits, inflation-beating growth, good profitability and low levels of debt.
Historically Rolls-Royce has more or less hit all of these targets, although problems in 2014 and 2015 have tarnished its record somewhat, as you can see in the chart below.
Although the company’s earnings have been slightly lumpy, the general picture is one of steady and fairly rapid growth. In fact, before the less than stellar results of 2015 the company’s growth rate had averaged around 9% per year.
However, that figure has come down as a consequence of a collapse in profits and a 50% cut in the latest final dividend.
A few years ago the idea of Rolls-Royce cutting its dividend was unthinkable, but thanks to an economic slowdown in some of its most important markets, an ongoing transition from old engine models to new models, and a relatively expensive cost-base, management have decided that a dividend cut is in the best interests of the company’s long-term future.
My key financial metrics for Rolls-Royce are as follows (compared to the FTSE 100):
- 10-Year growth rate = 5.1% (FTSE 100 = 2%)
- 10-Year growth quality (i.e. consistency) = 75% (FTSE 100 = 50%)
- 10-Year profitability = 8.3% (FTSE 100 estimated at 10%)
If you’re not familiar with those metrics then have a look at these investment strategy articles.
Overall then, Rolls-Royce has a better financial track record than the average large-cap company (i.e. the FTSE 100), but not spectacularly so. But as 2015 has shown, the company is a long way from being an unstoppable engine of growth and it does operate in a cyclical industry.
So that’s the (relatively) good news, let’s have a look at the bad news.
An extremely large pension scheme makes Rolls-Royce a riskier investment
As I mentioned at the beginning, Rolls-Royce’s pension scheme is one of the two main reasons why I don’t own the company.
I am wary of large pension schemes because they can more easily lead to large pension deficits, which companies are then legally obliged to reduce.
Whether or not Rolls-Royce’s pension scheme has a deficit today is not especially important, in my opinion. What matters is the size of the pension scheme’s liabilities and therefore the potential size of the deficit in future.
There is no magically correct maximum size for a pension scheme, but currently I use the following rule of thumb:
- Only invest in a company if its pension liabilities are less than ten-times its five-year average profit after tax
This is a ballpark figure which implies that a 10% deficit (a fairly typical figure) would result in a deficit equal in size to the company’s recent average profits.
My assumption is that a deficit of that size would result in a significant portion of the company’s cash flows being directed into the pension scheme, rather than into productive areas within the company or to shareholders as a dividend.
In Rolls-Royce’s case, it’s five-year average profits are £0.9 billion while its pension liabilities are more than £12 billion. The resulting pension ratio is clearly above 10 and so according to that measure Rolls-Royce’s pension scheme represents a significant risk to the company’s future prospects.
In addition, pension scheme liabilities have a nasty habit of going up every year. In fact, Rolls-Royce’s pension liabilities have increased from around £7.5 billion in 2009 to that £12 billion figure today. As they continue to go up so do the associated risks.
The share price has collapsed, but not enough to make me want to invest
Rolls-Royce’s share price peaked in late 2013 at almost 1,300p and yet today they stand about 50% lower at 670p.
That’s a pretty unpleasant decline to sit through and it reflects the degree of optimism embedded in the price a few years ago.
Investors thought the company would generate steadily growing cash flows forever, driven by its long service contracts. While those investors may be right in the long-term they were definitely wrong in the short-term.
At that peak price the company’s dividend yield was as low as 1.8%, so investors would have needed the company to keep growing by at least 8% each year in order to achieve the sort of 10% annual return that I’m after.
Today Rolls-Royce’s share price is much lower, but I’m still not convinced it’s low enough.
Let’s say we’re super-optimistic and that Rolls-Royce can return its dividend back to the 23.1p it reached before being cut.
At today’s price of 670p, a 23.1p dividend would still only give a dividend yield of 3.4%.
While 3.4% is a lot more attractive than a 1.8% yield, it’s below the FTSE 100’s yield of more than 4%, and would require (in theory) Rolls-Royce to grow its dividend by at least 6.4% each year to generate a 10% annual return for shareholders.
That may be possible, but as recent events have shown, even mid-single digit growth rates are hard to come by these days.
According to my stock screen, Rolls-Royce is worth about a fiver
If 670p is too much, what price would I pay?
I’ve given the game away with the heading above, but I’ll say it again for effect:
My current purchase price for Rolls-Royce is 500p.
Why 500p? The main reason is that at 500p the company would be one of the top-ranked stocks on my stock screen, rather than in the unexceptional 145th place out of 240, which is where it currently sits.
More simplistically, if we’re super-optimistic once again and assume that the dividend quickly regains its previous 23.1p peak, then a 500p share price would produce a dividend yield of 4.6%.
That’s the sort of yield I’m typically looking for. In this case it would mean Rolls-Royce does not have to grow exceptionally (unrealistically?) fast, after the initial recovery from its current problems, in order to generate a 10% annualised return.
Having said that, I still wouldn’t invest at 500p because of the large pension scheme.
But if the company did manage to come up with some way of massively reducing that financial liability then I would be happy to join the army of Rolls-Royce shareholders, but only at 500p or less.